What kinds of property can qualify for 1031, what uses of real estate are allowed, and how development affects 1031 status.
JTC’s team of 1031 exchange experts receives a lot of questions about IRC Section 1031, which outlines rules for the deferral of taxes on the buying and selling of business or investment real estate through like-kind exchanges. This part of the tax code has come under fire from critics, and there is a lot of misinformation out there.
“Section 1031 exchanges are often misunderstood as another tax strategy used by the wealthy or corporate companies as way to avoid paying taxes, when in actuality the transaction is more commonly used by the average real estate investor,” said Justin Amos, National Sales Manager & Account Executive at JTC. “From job creation, capital relocation, and potential to revitalize communities, 1031 exchanges offer more to the U.S. than meets the eye. Education for all parties involved will be key to the continued success of the program.”
Though Section 1031 has been a part of the Internal Revenue Code since 1921, there have been some changes in the last decade regarding what types of property can qualify. To better understand the current rules and what property types can be used in a 1031 exchange, here are the answers to some frequently-asked questions about 1031 real estate rules, developing land, vacation homes, and more.
Why are 1031 exchanges limited to real estate?
Section 1031 only applies to real property, but this wasn’t always the case. Prior to 2018, many types of business property could be used as part of a like-kind exchange. But a change to Section 1031(a)(1) meant that for exchanges made after 2017, Section 1031 would “apply only to qualifying exchanges of real property (within the meaning of § 1.1031(a)–3) that is held for productive use in a trade or business, or for investment, and that is not held primarily for sale.”
The result of this modification is that 1031 exchange treatment for “personal property” exchanges — such as buying and selling of tangible depreciable property, including aircraft, automobiles, and heavy equipment; or of intangibles, like patents — which had long been eligible for Section 1031 exchanges, would no longer be allowed.
Admittedly, for the average exchanger, this change won’t make a difference: commercial and investment real estate already made up the great majority of 1031 exchange property, and the existing rules for forward and reverse exchanges of real estate under Section 1031 remain unchanged.
Want to take the next step toward a successful exchange? Download our 1031 Exchange factsheet to learn about JTC’s 1031 solutions.
Can the buying and selling of multiple properties qualify for a 1031 exchange?
A typical 1031 exchange involves selling one like-kind business or investment property and purchasing another. However, selling one property and acquiring several replacement properties (or selling several properties and buying one replacement property) is also allowed, assuming the exchange follows all designated guidelines.
Although IRC Section 1031 enables a taxpayer to acquire multiple properties, it is important to remember that the identification rules apply differently to multiple property situations. An exchanger may identify up to three like-kind properties as replacement property per exchange, regardless of value, or any number of replacement properties as long as their aggregate value does not exceed 200% of the fair market value of the relinquished property. An exchanger can also identify any number of replacement properties as long as they actually acquire at least 95% of the value of all the properties that were identified.
These types of uncommon exchange scenarios can be complicated. Working with a Qualified Intermediary who is experienced with handling all types of exchanges is the best way to increase the likelihood of a successful exchange.
When does vacation property qualify for a 1031 exchange?
Taxpayers buying and selling vacation homes may assume their properties do not qualify for a 1031 exchange. However, in cases where vacation property has been primarily held for investment or business use, with occasional personal use, it may be possible to defer capital gains tax through a like-kind exchange. In order to qualify, both the relinquished and replacement properties must be held by the exchanger for productive use in a trade or business or for investment, not primarily for personal use.
Some properties, like vacation homes, may be used for both personal and business or investment purposes. For example, taxpayers who own vacation property may rent the property to others for the majority of the year, but still occasionally use it for personal enjoyment themselves. To account for these situations, the IRS issued Revenue Procedure 2008-16, which provides a safe harbor allowing dwelling units to qualify despite limited use for personal purposes.
To fulfill the safe harbor requirements and qualify for a 1031 exchange, the taxpayer must hold the relinquished or replacement vacation property for at least two years directly preceding or following the exchange. In each of the two 12-month periods preceding or following the exchange, the taxpayer must rent the property at fair market value for at least 14 days. The taxpayer may use the property for personal purposes for no more than 10% of the number of days the property was rented within the 12-month period, or 14 days, whichever is greater.
Both the relinquished and replacement properties being exchanged must meet the productive use or safe harbor requirements. Failure to comply with these requirements could jeopardize the outcome of the exchange and result in significant tax liability.
Does your rental property qualify for a 1031 exchange? Read our blog on 1031 exchanges and rental properties.
Can I buy undeveloped land, develop it, and then use it as relinquished property in a 1031 exchange?
Short answer: typically, no — but with some careful planning, it may be possible.
Usually, real estate acquired to develop and then sell does not qualify. As mentioned earlier, 1031 applies to real property “held for productive use in a trade or business, or for investment, and that is not held primarily for sale.”
What matters is intent: if you purchase undeveloped land with the intention of holding that asset as it appreciates in value, then it is held “for investment” and could qualify. But if you purchase it with the intention of building on it and then selling it, then it is being held “primarily for sale” and wouldn’t qualify.
If after developing the land, the property is held as investment property (or used in a trade or business) for a period of time, then the property could potentially qualify. For example, if the seller were to lease the developed property for several years to demonstrate a business or investment purpose, then an exchange could be possible.
Ultimately, whether a property can be sold as part of a 1031 exchange depends upon what the seller intended to do with it when they bought the property, but that intent can change over time. While the seller’s intent determines their ability to perform a 1031 exchange, it’s also very important that the seller’s actions following their acquisition of the undeveloped land be consistent with their intent. Exchangers are encouraged to consult with their tax and legal advisors to determine whether a property would meet the qualified use requirements of an exchange.
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